Abstract

This paper analyzes a randomized tax enforcement experiment in Denmark. In the base year, a stratified
and representative sample of over 40,000 individual income tax filers was selected for the experiment.
Half of the tax filers were randomly selected to be thoroughly audited, while the rest were deliberately
not audited. The following year, "threat-of-audit" letters were randomly assigned and sent to tax filers
in both groups. Using comprehensive administrative tax data, we present four main findings. First,
we find that the tax evasion rate is very small (0.3%) for income subject to third-party reporting, but
substantial (37%) for self-reported income. Since 95% of all income is third-party reported, the overall
evasion rate is very modest. Second, using bunching evidence around large and salient kink points
of the nonlinear income tax schedule, we find that marginal tax rates have a positive impact on tax
evasion, but that this effect is small in comparison to avoidance responses. Third, we find that prior
audits substantially increase self-reported income, implying that individuals update their beliefs about
detection probability based on experiencing an audit. Fourth, threat-of-audit letters also have a significant
effect on self-reported income, and the size of this effect depends positively on the audit probability
expressed in the letter. All these empirical results can be explained by extending the standard model
of (rational) tax evasion to allow for the key distinction between self-reported and third-party reported
incomes.